How Do Governments Reduce Inflation? – Forbes Advisor INDIA

Inflation is the increase in the price of goods and services in an economy. It translates to reducing the purchasing power of a currency. Measured by the Consumer Price Index (CPI), Inflation shows the impact of price changes for various products and services; it provides a single value representation of the increase in prices.

For any economy, inflation is a complicated phenomenon. While moderate inflation is suitable, it can create a disastrous economic situation if it exceeds a certain level. Here’s what causes inflation, how to curb it and what measures a government can take to control it.

Different Factors Affecting Inflation in an Economy

Growing Economy and Money Supply: When the money supply increases, liquidity rises, people’s purchasing power grows, and therefore, they’re willing to spend on necessities and luxuries. The increased demand for goods and services allows suppliers to raise prices. While an increased money supply may sound good, it also has its drawbacks, like devaluation of the domestic currency and contributing to inflation.

Disruption in Supply: When there is increased demand, the supply chain is negatively affected due to various factors. For example, during the pandemic, the supply of many goods was disrupted as customers were unwilling to spend much. When there is a demand-supply parity, the prices of goods and services increase as there is a shortage.

Poor Government Policies: The government must take specific measures to restrain the demand to a certain level. Inefficient decisions like not adjusting the interest rates in line with inflation every year, not managing the money supply within the country, among others, all lead to the inflation rate rising beyond control.

Inflation in India

There are two indices that are used to measure inflation in India — the consumer price index (CPI) and the wholesale price index (WPI). These two measure inflation on a monthly basis taking into account different approaches to calculate the change in prices of goods and services. The study helps the government and the Reserve Bank of India (RBI) to understand the price change in the market and thus keep a tab on inflation.

June CPI climbed to 7.01% compared with 6.26% last year while WPI stood at 15.18% vs. 12.07% last year.

Here are some factors that are influencing inflation in India:

Crude Oil Prices: The oil price shock has significantly contributed to the rising inflation in all oil-importing countries. In recent years, there have been a good number of fluctuations in oil prices, which has also led to high volatility in the commodity market. The increased inflation rate in April 2022 was primarily due to the costs of crude petroleum, natural gas, mineral oils, and essential metals. The fuel and light retail prices increase was 10.80% in April this year compared to 7.52% in March.

Brent crude was trading at $120 per barrel levels from March-June, hitting $139 per barrel, the highest since June 2008. With the fall in demand for crude and the rise in recession fear, the price sank to $99.9 per barrel.

Russia Ukraine War: The retail Inflation rose mainly because of the rising prices of food and other essential items. India imports a significant portion of sunflower oil from Ukraine, which is the major exporter of this commodity. Moreover, Ukraine is also a substantial exporter of fertilizers for India. Due to war situations, uncertainties, and trade cut-offs, there has been a supply shortage in these commodities instead of a never-ending rise in demand. This deficit in demand and supply has further induced the inflation of essential items.

Rupee Depreciation: For over a decade, the rupee has depreciated against the US dollar. It has seen a fall of more than

Rupee Depreciation: For over a decade, the rupee has depreciated against the US dollar. It has seen a fall of more than 7% in the last year. The USD has been growing strong against major currencies in the world.

How Can the Indian Government Control Inflation?

Being an import-oriented country, India has to purchase (import) raw materials and other goods at a higher price due to higher dollar value. Importing at a high cost increases the cost of production, leading to higher costs of the final goods or services, thereby causing inflation in the Consumer Price Index.

The government uses monetary and fiscal measures to control inflation.

Monetary Policies

One significant monetary way to curb inflation is to control the money supply in the economy. If the money supply goes down, the demand for goods will decrease, causing a price fall. Another way to curb the money supply is when the government withdraws specific paper notes or coins from circulation. Lowering the lending rate for commercial banks allows money circulation to be controlled. The Central Bank can also block commercial banks’ money by issuing government securities.

Fiscal Policies

The two essential components of a fiscal policy are government revenue and expenditure. The government can change its tax rates to increase revenue or efficiently manage expenditure. An inflationary gap is created when the demand is higher than the supply. The government can tackle this in two ways.

One, by decreasing the overall government expenditure and transfer payments. Two, increasing the tax rates leads to decreased individual demand and a drop in the economy’s money supply.

Steps the Indian Government Has Taken to Curb Inflation

With the CPI number touching a high of 7.79%, the RBI Governor has announced several steps to control price rise in the country:

  • The RBI has consecutively hiked the repo rates in May and June. The rate hike by 0.90% in the two months. The RBI is expected to hike it further to control inflation.
  • The government has announced an excise tax cut on petrol and diesel. The government will bear a shortfall of INR 1 lakh crore due to the excise duty cut on petrol and diesel. With the fall in the per barrel rate of crude oil, there has been a further reduction in the fuel prices in India.
  • The government announced a reduction in the import duty on critical raw materials for production and inputs for the steel and plastic industry—the reduced cost of production, thereby causing stability in the prices of the final goods.
  • The government allowed duty-free imports of 20 lakh tons of crude sunflower oil for the next two years.
  • The government has capped sugar exports and banned wheat exports altogether. It is mainly to maintain adequate stock and food security within the country and to cool off prices.

The Bottom Line

Given the excessive volatility in global crude oil prices since late February, inflation is likely to remain volatile. The rate is contingent upon future oil and commodity price developments. Considering RBI’s past measures, we can also successfully predict India’s central bank taking additional rate hike measures to reduce inflation within acceptable limits.

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